Q: Reader Suzanne Herman, who says she’s Canadian with U.S. citizenship, submitted this question: “What clever way could one avoid paying U.S. capital gains on the sale of a real estate, and still retain the capital gains exemption on the sale of a principal residence in the country where one lives?

There are a number of ways to optimize one’s tax situation with respect to capital gains on the sale of a residence overseas, though individual circumstances will dictate whether any of these methods can be used, and many are applicable to domestic residences as well. From a U.S. tax standpoint, all of the following will apply:

– using the $250,000 exemption on the principal residence
– keeping ownership in the name of the “foreign (Alien) spouse”
– capital improvements will increase the adjusted cost base
– gifting to the “non-citizen spouse” including the annual $145,000 (approximate Gift tax exemption)

If any foreign taxes are paid on the capital gains from selling a foreign residence, these taxes can be used as a foreign tax credit to offset U.S. capital gains taxes owed. Many countries do not have an exemption on 100% of the gains of a principal residence.

Capital gains rules will factor in the U.S. dollar price at the time of sale minus the U.S. dollar price at the time of the purchase. Capital gains tax may be owed in the U.S. only due to an exchange-rate move even if you have a loss in local currency.

Paying off a mortgage in foreign currency can also result in an unexpected nasty tax consequence since U.S. individuals can’t use a foreign functional currency. They must do all of their accounting in U.S. dollars. Here is an example:

A single Individual X buys a home for 2,000,000 Swiss francs (at the time 1 U.S. dollar = 1 Swiss franc) and takes on an interest-only mortgage of 1,000,000 Swiss francs.

Individual X lives in the home for five years (now the exchange rate is 1 U.S. dollar = 1.3 Swiss francs) and the individual sells the home for 3,000,000 Swiss Francs

X’s sale price in dollars is $2,307,692 – $2,000,000 purchase price, so there’s a capital gain of $307,692. Subtracting the $250,000 exclusion, $57,692 would be subject to capital gains tax.

However, there will be more taxes to pay. The mortgage was worth $1,000,000 in the year of purchase and only $769,231 at the time of the sale = a gain of $230,769. Exchange-rate gains are taxed at ordinary rates. If taxpayer X is in the top marginal rate, he could pay 39.6% on this gain, so an additional $91,384, and he may also be subject to the 3.8% Net Investment Income Tax on top of that. If instead the taxpayer has a loss due to the exchange-rate fluctuation, he is out of luck, because it would be considered a non-deductible personal loss.

More from Jonathan Lachowitz:

Jonathan Lachowitz does great summary of new more reasonable IRS rules for frightened overseas Americans.
http://t.co/qp8H9HpLvn